SEC Question and Answer of General Applicability 123.18

SEC Question 123.18

Question: Are the dispositions of issuer securities that take place in cashless exercises through a broker eligible for exemption pursuant to Rule 16b-3(e)?

SEC Answer
 

Answer: No. The dispositions that take place pursuant to these transactions are not eligible for exemption pursuant to Rule 16b-3(e) because cashless exercises through a broker do not involve a transaction with the issuer or the issuer's employee benefit plan. [May 23, 2007]

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So here is the SEC Staff stating that dispositions of issuer securities through a broker for cashless exercises are not exempt from Section 16 (b) because the transaction is not a transaction with the issuer (i.e. not a transaction between the officer or director and the issuer).

The transaction is between the officer or director and the broker. Therefore the transaction is not exempt from Section 16 (b).

Now is the SEC Correct in answering NO to the question?

So first we have to understand what is a cashless exercise through a broker?

Below is a quote from an article by attorneys Foley & Lardner LLC

"In a cashless exercise through a broker, the issuer agrees to deliver the stock issuable upon exercise of the employee stock option to the broker, and the broker agrees to deliver the exercise price and withholding taxes to the issuer out of the proceeds from the short sale of the shares. The employee borrows shares for the short sale, and the issuer delivers the shares underlying the exercised option to enable the employee to close out the short sale."

For example:

Assume that an executive was granted 10,000 ESOs when the stock was trading for $20.00 and three years later the stock is trading for $50.00 and the executive exercises. The executive owes the exercise price of $200,000 and perhaps 50% of the profit for taxes.

Assume that the cashless exercise is required and the issuer delivers the 10,000 shares to the broker. The executive then short sells enough stock (6500 shares) to pay the exercise price and the taxes. The broker delivers the proceeds from the short sale to the issuer and the executive receives the 3500 shares from the broker. 

So since there is no transaction between the executive and the issuer, there is no exemption from section 16 (b) via SEC Rule 16 b-3, even if the  shares came from the issuer to the broker. 

However, if there was no required cashless exercise but the executive was required to deliver shares to the issuer upon exercise of ESOs sufficient for the exercise price and taxes, would there be an exemption from section 16 (b) via Rule 16 b-3 with condition (e). The executive is seldom required to deliver shares to the issuer for taxes and the exercise price.

Most plans give the executive the choice of giving shares to the issuer for the exercise price and the taxes or sending cash to the issuer. Under the circumstances where the executive has a choice or when the issuer has a choice, there is no exemption according to SEC staff opinions.

In summary, to get an exemption from 16 (b), the transaction must involve issuer equity securities and be between the issuer and the executive whether the transaction if from the issuer or to the issuer.

However, when the Equity Compensation Plans are designed, the designers are trying to allow maximum wealth extraction from the company to the top executives. 

When section 16 (b) is violated the company attorneys seldom admit the violations and seek to not have the insiders pay the recovery.

John Olagues